This auction is two weeks away, so I thought I’d take a preliminary peek at it. This will be a reissue of CUSIP 912828UX6, which first auctioned on April 18 with a yield to maturity of -1.311%. This 4-year, 8-month reissue will carry the existing coupon rate of 0.125%.
If you liked it in April … Obviously, a lot has happened since April, with TIPS yields rising dramatically for two reasons: 1) the Federal Reserve’s announced plan to begin tapering its Treasury-buying program if the economy continues improving, and 2) a trend of sluggish U.S. inflation, which makes TIPS less attractive to investors.
Here’s a recap of 5-year TIPS yields in 2013, demonstrating that even as nominal Treasury rates rose, and even after a recent decline in TIPS yields, TIPS have become less expensive compared to a traditional Treasury:
|Date||5-year TIPS||5-year Treasury||Inflation Breakeven|
Although you see negative yields in this list for the TIPS, that negative rate is offset by inflation. The base principal of a TIPS increases with inflation until maturity. That is why the breakeven rate is so important. Right now, a 5-year TIPS will outperform a 5-year Treasury if inflation averages more than 1.93% over the next 5 years.
Inflation over the last five years has averaged 1.3%, but that was only the second time it has been under 2.0% in a five-year period in the last 50 years. See a chart.
As of Wednesday, CUSIP 912828UX6 was trading on the secondary market at -0.670%, a little worse than the Treasury estimate listed above for a full 5-year TIPS.
Because it carries a coupon rate of 0.125%, buyers will be ‘paying up’ to get the resulting negative yield. My guess currently is about $10,325 for $10,000 of value, down from about $10,782 when the TIPS was first auctioned.
Danger in paying up. While your principal is guaranteed at maturity, the amount you pay up is not guaranteed. If we see 5 years of deflation, a buyer paying $10,325 this month will get $10,000 back at maturity, along with earning 01.25%. I consider this highly unlikely, but it is worth noting.
Alternatives? There is no doubt that the US Savings I Bond is superior to a 5-year TIPS. It pays the rate of inflation, minus nothing, has rock-solid deflation protection and is tax-deferred until maturity, which can be anywhere (without penalty) from 5 years to 30 years. The hitch is that you can buy only $10,000 per person per year. (You can also get additional paper I Bonds in lieu of income tax refund.)
What about insured bank CDs? My local credit union is paying 1.30% on 5-year CD, less than a 5-year Treasury. You can shop around and find better rates, possibly up to 2.0%, which would push the breakeven rate up to 2.55%. A bank CD with a high rate is pretty competitive, if you can find those ‘lofty’ rates.
Trend is working against buyers. The 5-year TIPS yield has dropped 10 basis points since Aug. 1, and 28 basis points since July 5. It’s a trend worth watching. While I would like to add this TIPS to my bond ladder, I am going to keep an eye on that yield.
A lot can happen in two weeks.